Inflation hedging activity saw a jump towards the end of last year as medium-sized schemes took advantage of favourable pricing, ahead of further inflation falls.
But consultants have warned against failing to combine this with medium-term interest rate protection as inflation dips to 0.5 per cent, its lowest point since 2000.
In Q3 2014, total inflation hedging activity rose 27 per cent quarter-on-quarter, according to research by asset manager F&C Investments published this week, as expectations of interest rate rises made the price of hedging look attractive. But with the consumer price index having hit 0.5 per cent, interest rates are expected to stay lower for longer.
Alex Soulsby, head of liability-driven investment at F&C, said increasing numbers of medium-sized schemes have been mandating an LDI manager in a bid to derisk.
“Smaller and medium schemes have been going through a learning period and learning lots more about it,” he said. “The biggest increase has been from the medium-sized schemes, which I guess are catching up.”
Lynda Whitney, partner at consultancy Aon Hewitt, said it has continued to see interest in hedging from smaller schemes, despite falls in yields, as it would be a bigger bet not to hedge.
“If [smaller schemes] haven’t started, they should be taking the first steps of hedging,” Whitney said. “It is now over 10 years since LDI first came available and scheme size is not a barrier today.”
Soulsby said many schemes are looking to reduce risk after seeing strong equity returns or sponsor contributions into the fund, which have improved relative funding levels.
“Because now they understand the risk they have from interest rate and inflation they’re trying to reduce that risk, and that’s locking into the relatively healthy situation they’re in,” he said.
But Jignesh Sheth, director of investment consulting at JLT Employee Benefits, said the risk posed by deflation and demand for hedging outpacing supply have led to a lower-than-expected fall in the cost of hedging inflation. Smaller schemes had been looking more closely at both their inflation and interest rate exposure, he added.
“This focus has tended to concentrate on turning nominal into real hedges due to concerns that hedging on an inflation-only basis increases a scheme’s funding level risk,” Sheth said.
Robert Skelton, investment consultant at Xafinity Consulting, agreed that hedging inflation alone could lead to increases in schemes’ funding risk.
He said: “Those that have hedged inflation only, and not at least held conventional bonds to provide medium-term interest rate protection, will have suffered losses on both their inflation hedging and their unmatched interest rate exposure.”
Whitney said hedging should be driven by a desire to remove risk rather than trying to time the market. “Remember, you should not focus on the level of inflation today,” she said. “It is only if you have a difference of view to the market yield curve or market inflation curves that might influence when to hedge.”
